Cost–Benefit Analysis

The Framework

CBA or benefit–cost analysis (BCA; these terms are used interchangeably) is an accounting framework for government projects. In this framework, benefits and costs associated with a public investment or decision are laid out for purposes of information and discussion. A related framework, widely used in health care but also in other areas, is cost-effectiveness analysis, sometimes known as least cost planning. In least cost planning, the goal is given, for example, to achieve a given level of carbon monoxide in a city, and the least expensive way of achieving this goal is sought.

Externalities

The rationale for government investment is externalities. Externalities are effects that are not accounted for in market operations. They arise solely from the expenses of operating markets. Air pollution, for example, is considered an externality as the polluting firm does not take into account the damaging effect of its pollution on the surrounding population. In a market system, the population could pay the firm to reduce pollution. Or the firm could pay the individuals to tolerate it, whichever course was the cheapest. Yet any such market arrangement might be too expensive to implement due to transaction costs. Sometimes the government can institute a quasi market as in cap-and-trade permits. In this case, the government fixes the quantity of pollution allowed and then sells (or gives away) rights to this quantity. These rights can then be traded. This sort of arrangement is increasingly used in fisheries to prevent overfishing. The total quota of fish allowed to be caught is set and rights are then distributed among fishermen for portions of the total quota. The decision about whether to use a quota system, or to use, say, pollution taxes or emissions limits on the basis of the available technology is the sort of decision that CBA can be used to address. More commonly, CBA is used to address questions in areas such as transportation, dam building, and, more recently, expenditures on social programs such as Head Start.

Government Use

The U.S. Federal Government widely uses CBA under presidential executive orders. Under these orders, the Office of Management and the Budget (OMB) requires the use of CBA by executive agencies and many congressional agencies as well. OMB has created a set of guidelines for the use of CBA. [Page 484]CBA is also used, but less widely, by state and municipal governments. If used properly, the CBA framework can reduce poorly conceived government spending. In fact, it has already played this role to a significant extent but not to the extent possible.

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